Elliott Parker : Recessions, taxes and the growing federal deficit

The federal deficit in 2009 hit a postwar record. Many assume that this deficit is the result of out-of-control spending, but is this entirely true?

In the debate over government spending and the deficit, economists usually look at the size of government compared to the economy's Gross Domestic Product. During a recession, government spending usually increases as a share of GDP. Some kinds of spending increase automatically, while other discretionary spending may also increase in an effort to stabilize the economy.

But we forget that this ratio will also rise because GDP is falling, even if government spending is constant. That is, government spending becomes a relatively bigger share of a smaller pie.

The key is to first smooth out GDP so it grows at a stable rate, and see how government spending compares with that. Adjusting for inflation and population growth, we find that real per-capita GDP grew by about 2.2 percent a year from 1950 to 2000, so let's use that to figure the trend.

This graph shows how federal spending and tax receipts have changed since 1950, relative to our trend GDP. It also shows total spending for all state and local governments, but we don't need to bother with revenues because they generally have to balance their budgets.

Federal spending rose significantly in the 1960s, to 20 percent of trend GDP, and then rose again to 23 percent by 1985. This ratio gradually fell to 19 percent by 2000, and remained relatively steady until 2007.

State and local government spending followed a similar pattern, with spending doubling from 5 percent of the economy in 1950 to 10 percent in 1975, remaining more or less steady afterwards.

While state and local revenues must match their spending, revenues didn't always keep up with spending on the federal side. Deficits tend to rise during recessions, but before 1970 the federal budget was balanced on average. Then deficits became acceptable, sometimes even when the economy wasn't in recession.

During the Reagan administration, these deficits reached postwar records due to tax cuts, increases in military spending, and the worst postwar recession at that time. During the Clinton administration, the federal budget finally returned to surplus, helped by tax increases and economic growth.

After 2000, tax cuts and a recession led to deficits again. Unfortunately, the economy never really caught back up, and by 2007 our economy was 5 percent below where we would have been had we kept growing at the trend rate. In 2008 we hit this awful recession, and by last year our actual GDP was 13 percent below the trend, a serious decline indeed. Less income leads to fewer taxes paid.

In response, the share of state and local spending was cut more than anytime since 1934. The share of federal government expenditures rose, partly to bail out the states to prevent even more cuts. But most of all, federal taxes fell dramatically. Reduced tax collections were amplified by more tax cuts as the federal government tried to slow the economy's contraction.

How do we restore balance to the budget? In the short-term, the best thing to do is to restore growth. If the economy recovers, tax collections will rebound, too. Letting the last decade's tax cuts expire might also significantly reduce the deficit.

In the long-term, of course, there are other budget-busting trends we will need to manage, like the growth of Medicare spending and rising interest payments on the national debt. These are serious future concerns, but they are not really the cause of current deficits.

• Elliott Parker is professor and chair of the UNR Economics Department.